Research Roundup: Investment Ideas for the Week of June 27

Research Affiliates sees high inflation, low growth in the developed world. BlackRock looks for companies with strong cash flow. Gold prices rise.

Jason Hsu, Research Affiliates

The 3-D Hurricane and the New Normal*

Debt, deficit, and demographics—the 3-D hurricane— is heading to the shores of all developed economies. It threatens to derail the lukewarm economic recovery and to alter forever the heretofore path of robust growth for the developed world. In a sense, debt, deficit, and demographics will reset the world to a “New Normal”—an extended period of lower economic and return expectations for the aging and debt-ridden developed world.

In contrast, emerging economies with healthy government and household balance sheets, responsible fiscal policies, and young labor forces will be the drivers for global growth and will compete with their developed counterparts for economic and political leadership. More importantly, the emerging economies will demand their fair share in the consumption of resources and goods. That competition for resources and goods will lead to higher prices at a time when developed countries are less able to further finance their consumption. Finance plays a critical role in the real economy, though only an intermediation activity. Shocks to financing for the developed economies—whether through high interest rates due to poor sovereign credit risk or through the crowding out effect from government deficit financing—would have long-term effects on economic growth and the unemployment rate.

By comparison, emerging countries have low debt-to-GDP ratios. Specifically, the Asian EM countries generally maintain trade surpluses and, therefore, also act as suppliers of global capital to the debt-laden developed economies. These healthier balance sheets, over time, mean that emerging economies would represent lower credit risk than many of their developed counterparts. The trend of declining credit spread for EM debt has been occurring for many years. In the New Normal, emerging countries will not only converge with the developed countries, but in fact are likely to overtake many of them in short order. From the credit spread for developed sovereign debt versus emerging sovereign debt, capital markets may not have fully comprehended this pending reversal of fortune between the developed and developing economies. Emerging economies currently are assessed higher credit spreads versus developed economies, although they often have significantly better underlying collateral quality and debt capacity. This reflects an irrational bias on the part of investors; it is not unfathomable that a re-pricing of developed market sovereign credit risk is forthcoming for even the most stalwart of the developed economies—Germany and the United States.

When Deficit becomes Odious Debt

The extensive literature exploring the effects of deficit driven stimulus programs provides strong evidence that short-term growth, financed by deficit spending, rarely translates into sustained long-term growth.2 The argument is that government-directed investments are often zero or even negative net present value (NPV) projects—that is, they tend to be suboptimal investments. From that perspective, government stimulus programs are more about creating make-work jobs than investing in infrastructure and education that will drive future growth. The short-term increase in economic activity does not translate into future increases in production of valuable goods and services.

In a true Keynesian sense, government recessionary expenditure aims purely to smooth temporary shocks; it cannot substitute for private sector investments which are necessary to drive long-term growth. Insofar that the government stimulus is financed by more debt, it necessarily translates into higher future tax burdens, which then drains future private sector consumption and investments. By backward induction, a higher future tax burden decreases expected (after-tax) return on investments, which then reduces private sector investments today. Crowding out future and current private sector activities by the public sector growth today bodes ominously for future growth. Indeed, under standard economic theory, the government either borrows to invest for future growth, and therefore drive future tax revenue, or it borrows to shift future consumption to the present in an attempt to ameliorate shocks to the economy.

In reality, deficits have a tendency to become ever-increasing debt. We have been all too willing to believe the story that future growth driven by indomitable American ingenuity will deliver us from our debt. Unfortunately, unless another decade-long period of explosive technology innovation is in the cards for us, we may have just now hit a wall: The debt-to-GDP ratios for many developed countries have become untenable; additional borrowing capacity is small. In hindsight, the policy of persistent deficit spending seems utterly irrational and short-sighted. On the other hand, one might argue that this outcome is exactly rational in the context of baby boom demographics prevalent in the developed countries. Deficit spending gives an instant and immediate boost to GDP, which can feel like prosperity and good government stewardship. The natural conflict between the future non-taxpayers and the future taxpayers means that Boomers, who have controlled the elections and politics, have rationally chosen a path of more consumption today at the expense of the future generations. Whether deficit spending truly has any significant impact on subsequent growth is rather irrelevant to the discussion; voters and politicians alike would simply misinterpret the economic literature and assume more consumption today will drive more growth tomorrow. In other words, and as scientific as one can put it—the Boomers have screwed Generation X.

Democracy is one of the great equalizers for income inequality in the cross-section of population. The poor have a mechanism to instigate wealth transfers by voting for welfare and public goods production and to avoid exploitation by voting for pro-labor regulations. Democracy seems to serve quite the opposite role, however, when it comes to equalizing the inequality between generational cohorts. There is no doubt that our future generations have become extremely poor; they are each responsible for tens of thousands of dollars in national debt—in some countries, Gen Xers are staring at outright national bankruptcy. But today, our political process continues to allow the Boomers to pile on new debt for the next generation in order to fund their current consumption and future retirement. It appears that democracy has facilitated the exploitation of our future poor by the current rich and indeed has been a strong contributor to what will become the Boomer’s legacy of odious debt. The great deleveraging, which has been proposed as the only responsible course of action for the developed countries after the global financial crisis, never materialized and calls for fiscal austerity have largely fallen on deaf ears. The Boomers around the world have written into law rich benefits for themselves, which have to be financed by tax dollars from future generations. Adding insult to injury, they have also pre-spent future tax revenues through massive deficit spending today. The combined weight of the explicit debt and implicit government- guaranteed obligations (such as state pensions and healthcare benefits) has begun to stress most of the developed economies and is already crushing some.

Does Monetary Policy help?

Mounting debts—whether implicit or explicit—are a long-term issue that Boomers are passing to the next generation. In the shorter term, the recent U.S. government monetary intervention (namely, QE2) has drawn many people’s attention. What, exactly, has QE2 accomplished? Although many equate quantitative easing with the printing of money, it is not entirely accurate or useful to do so. The Fed bought long-term Treasury securities from banks and issued interest-bearing reserves in return. When reserves pay interest, they are no different than T-bills; both are short-term government securities paying similar interest rates. The appropriate way to think about QE2 is to recognize that the U.S. government simply refinanced its long-term bonds with short-term bills. If not for all the media hoopla, it has been an otherwise rather unspectacular shift in financing arrangement. No money was printed in the sense that the monetary base did not expand. Arguably, liquidity in the marketplace did not improve materially as banks do not appear to have reduced their government debt holdings in favor of other investments.

Perhaps QE2 has had an impact on interest rates. The evidence here is rather mixed. There is some weak evidence that long rates moved higher due to increased inflation expectations, while other evidence suggests that Treasury yields experienced only a brief and temporary shock before recovering back to their old trend. Some market pundits have observed various indicators of increased speculation in the financial markets (mostly from increases in speculative positions reported by commodities traders). They argue that the large excess reserve balances held by the banks allowed banks and their related investment arms to engage in greater risk taking. The theory is that banks used their low-yielding reserves as collateral to engage in financial speculation (instead of making loans). As a result, these speculative activities seem to have resulted in higher commodity and stock prices. Whether this theory tests out or not, we do nonetheless observe ample evidence of Federal Reserve Chairman Ben S. Bernanke taking credit for the strong stock market performance as a result of the Fed’s easing policy. The wisdom of the Fed attempting to create prosperity by stimulating the stock market is debatable. Clearly, such effects can only be transient as prices ultimately are related to the underlying fundamentals. We also note that higher prices today benefit current shareholders result in low forward-looking returns for future shareholders. In that context, one might argue the attempt to influence asset prices is no different than a wealth transfer from the future generation to the current generation. Alarmingly, it appears that our fiscal and monetary policies are both geared toward exploiting our heirs.

As the country prepares for retiring Boomers (and the debt and deficits associated with them), it will also need to prepare for changing demographics—specifically, the adverse effects driven by the dramatic decline in the support ratio associated with an aging population. It is projected that the support ratio in developed countries will decline from 3.5 working age adults per retiree to below 2:1 by 2050. In comparison, in 1970, the support ratio was 5.3:1. By 2025, at the height of Boomer retirement cycle in the United States, there will be 10 new retirees for each new entrant into the workforce. Not only does the future appear unenviably poor in aggregate, it also appears predictably unproductive. People consume goods and services which are produced by workers. A sharp decline in the United States and developed country workforce means that Americans, and their European and Japanese counterparts, must either reduce consumption drastically or increase reliance on imports from emerging countries. Thus, the trade deficit between developed countries and the emerging countries must continue to widen aggressively or the standard of living for developed countries must decline precipitously. However, the only way for most developed countries to maintain (and increase) their trade deficit against the emerging countries is to borrow heavily from the emerging countries. If the PIIGS are any indication of what is to come, the balance sheet, and ultimately the credit rating, of the developed economies simply would not allow further aggressive borrowing.

Historically, demographic shifts have had little impact on markets. However, the analysis could change dramatically at debt-to-GDP ratios above 100%, which is a phenomenon not seen in history. The linkage between demographics and debt cannot be overemphasized. Demographic shifts are generally considered to be non-risk events, in that they can be fully anticipated ahead of time. Economies with rational agents, saving, consumption, and investment decisions would allow individuals to largely manage the (adverse) effects of (unfavorable) demographic shifts. Boomers should have anticipated the untenable support ratios in their retirement. They were supposed to save aggressively during their working years (delaying pre-retirement consumption) and then convert their large and plentiful retirement assets into retirement consumption, particularly paying up for imported goods. Specifically, Boomers should have anticipated the weakening of their home currencies as their economies run greater trade deficits against the younger EM economies. Boomers should also have anticipated a significant rise in the cost of domestic services, which cannot be effectively imported from foreign labor markets. Instead, what we observe today is inadequate retirement savings. It is long understood that the pay-as-you-go social security scheme cannot work effectively as a credible mechanism for intergenerational risk-sharing in the face of declining support ratios; as the population ages and fewer workers enter the workforce relative to workers exiting into retirement. There are insufficient numbers of young people paying into the system to support the social security payments for those who have retired. Pension schemes, or forced retirement savings, should have protected workers from the problems associated with aging demographics. Unfortunately, low contributions, high costs, and poor governance and institutional design have generally led to poor funding and adequacy ratios. The problem is further compounded by an inability to further borrow against the production of the future generation. This failure is not due to a lack of political will and mechanism to exploit the future, but by the inconvenient reality that the future has already been fully monetized—rating agencies and international lenders are starting to be uncomfortable with the debt capacity of the developed countries. What was a predictable inevitability—the reality of an aging population—that could have been managed will become a shock that surprises economies and markets. Instead of a gradual and smooth change in rates and prices corresponding with the gradual shift in demographics, the likely outcome is a volatile and violent transition from the old equilibrium to the new.

In recent years, FOMC forecasts have evolved towards weaker growth and a higher unemployment rate.

Despite higher expected unemployment, the FOMC has increased its forecasts for overall and core inflation, implying a worsening inflation-unemployment trade-off.

The rise in expected inflation helps explain why the Fed is reluctant to enact further stimulus measures, despite elevated unemployment.

The FOMC’s statement at this week’s meeting was mostly in line with our expectations. The Committee acknowledged the weaker data since the April meeting, but said it considered part of the weakness to be temporary and related to higher energy and food prices and supply-chain disruptions from the earthquake and tsunami in Japan. However, the FOMC changed its language on inflation. It said: “Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions,” adding that it “anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate.” This differed sharply from the April statement, which said: “inflation has picked up in recent months, but…measures of underlying inflation are still subdued.” In fact, it was the first time in more than a year, that the Committee did not mention underlying inflation in its statement, suggesting that it may no longer be drawing much comfort from the behavior of core inflation.

FOMC looks for weaker growth, higher unemployment and higher inflation We have looked at the evolution of FOMC forecasts for this year. Figure 1 shows the history of the Committee’s 2011 growth and unemployment rate forecasts. Since the beginning of 2009, the midpoint of the FOMC’s central tendency projection for growth has been steadily cut, from 4.4% in January 2009 to 2.8% this week. Along with weaker growth, the unemployment projection for Q4 11 has been raised significantly, from 7.1% in January 2009 to 8.8% this week. Typically, a higher unemployment rate would be expected to be accompanied by lower inflation readings, but over this period the FOMC has raised its PCE inflation forecast from 1.3% in January 2009 to 2.4% this week, and increased its core PCE inflation forecast from 1.1% to 1.7%. (Figure 2) Thus, the projections imply a worsening trade-off between unemployment and inflation than the FOMC had previously expected. One reason for this pattern is higher energy prices, which typically weaken growth, raise unemployment and boost inflation simultaneously. However, it appears that the FOMC believes that some of the worsening unemployment-inflation trade-off will persist into 2012 and 2013. As Figure 3 shows, the FOMC has generally been cutting its growth forecast for 2012 since it began forecasting it in November 2009, and it has been raising its unemployment forecast. Despite higher expected unemployment, the FOMC’s inflation forecasts for 2012 have been drifting higher, and it expects both headline and core inflation to be within its preferred range of 1.7-2.0% in 2012, (Figure 4) despite an unemployment rate forecast to remain above 8.0% throughout the year. Furthermore, the FOMC’s 2013 forecast (not shown here) puts overall and core inflation in this range, despite the fact that the unemployment rate is expected to remain far above its estimate of the natural rate of unemployment of 5.2-5.6%.

The worsening trade-off leaves less room for further stimulus The implications of these forecast revisions are striking. The Fed expects inflation to be within its preferred range through the end of 2013, despite high unemployment. This helps explain its reluctance to launch another asset purchase program. When the last asset purchase program was launched in November, the Fed expected both overall and core inflation to be “too low” relative to its mandate throughout the forecast period. If the asset purchase program led to a lower dollar, higher import prices, and higher inflation, this was seen as desirable because it would push inflation up toward the mandate-consistent level. Now, however, with inflation expected to be at the mandate-consistent level throughout the forecast period, the Fed seems reluctant to risk pushing it higher with more stimulus. In our view, only if growth disappoints in H2 11 and the Fed becomes more convinced that it does not need to worry about inflationary consequences is it likely to consider another asset purchase program.

Bob Doll, BlackRock

Amid ongoing crosscurrents in the economy and markets, the nonfinancial corporate sector has been a vast and dependable source of strength. The last few years have seen US firms earn near-record profits and accumulate unprecedented levels of cash — the result of bold actions taken to combat the worst market downturn since the Great Depression. The collective cash balance for US companies (as represented by the S&P 500 Index) ballooned to more than $1 trillion at the end of 2010. With returns on cash virtually non-existent, conventional wisdom dictates that companies will have to act. Accordingly, capital deployment is taking center stage.

In this report, Bob Doll, BlackRock’s Chief Equity Strategist for Fundamental Equities and head of the US Large Cap Series equity team, examines the various options available for company managements looking to put excess cash to work. Among them: reinvesting in operations, acquiring strategically and/or financially compelling businesses, buying back shares and initiating/raising dividend payments. Regardless of the route taken, each of these strategies should benefit equities and help to create investment opportunities.

Business Investment

Business investment is often the first consideration when it comes to corporate cash deployment and value creation. Business investment allows for organic growth and generally consists of capital expenditures, including the purchase of plant, property and equipment, as well as technological and/or intellectual property investments via research and development.

Such investment is important in the macro sense because the amount companies are willing to reinvest in their businesses is a sign of their vitality and, therefore, inextricably tied to economic growth. At the individual-company level, the amount of spending is often a harbinger of a corporation’s expansion plans such that an increase indicates preparations to grow operations, while a decrease suggests the opposite. Likewise, it is a statement on the future, reflecting corporate management’s confidence in the economy.

Business investment has been particularly relevant over the past few years, when capital expenditures plunged amid demand uncertainty and corporate conservatism resulting from the financial crisis. Even as US corporations’ desire to retreat and tighten spending was expected and logical, the magnitude of the retrenchment was dramatic, as seen in the following chart. This trend cannot be sustained, in our view. It goes without saying that innovation and reinvestment are critical to maintaining and growing market share. Whether upgrading existing products and services, bringing new value-added offerings to market or suspending unproductive ventures, companies stand to gain by demonstrating operational focus, enhancing competitive advantages and, ultimately, boosting volumes. The bottom line is that companies desiring to refresh their businesses and grow will have to start dipping into their cash reserves to do so.

Indeed, business investment has been steadily on the rise, but it remains a long way from normal levels. Though recent months have seen a mild slowdown in economic activity, we believe corporate managements are growing increasingly more comfortable with the recovery. At the same time, profit growth shows no signs of abating. This, coupled with companies’ deliberate underinvestment over the prior few years, augurs for stronger capital spending — and, likewise, continued economic expansion — in the coming months and years.

Mergers & Acquisitions (M&A)

For companies seeking to augment organic growth, M&A represents a potentially valuable capital allocation strategy. Like business investment, deal activity virtually ground to a halt in the aftermath of the financial crisis as bruised corporate executives abandoned M&A plans in the face of deep uncertainty. Here, too, there has been growing evidence of a turnaround, and it is quite convincing. The following exhibit shows that M&A activity is increasing from cyclically-depressed levels, and we believe it could be on the way to a new record.

Historically, we’ve tended to greet M&A announcements with a bit of caution. This is primarily because academic and practical analyses revealed that, in the majority of cases, target companies’ shareholders retained all of the value created, while value was destroyed for shareholders of acquiring companies. We think the environment has changed. In fact, more recent evidence indicates that M&A can be a value-creating action for both the acquisition target and the acquirer — the key is for acquiring company managements to be disciplined and strategic in their pursuit. “Disciplined” essentially refers to paying the right price. Overpayment for an acquisition, generally based on overestimated worth, is among the prime destroyers of shareholder value (as seen in the tech bubble in the early 2000s). “Strategic” refers to the motivation behind the deal. The business rationale can include growing scale, adding new (or complementary) capabilities and recasting a business model. While some rationales are more strategic than others, the important takeaway is that there must be a “why” as the basis for all that follows. Beyond discipline and strategy, operational and cost synergies are important considerations as well. At present, we believe economic and market conditions are coalescing in favor of further acceleration in M&A activity. To the extent cash-rich corporations become more aggressive in putting their capital to work (and we believe they will), the combination of a neutral-to-positive economic backdrop, an improving equity outlook, increasing corporate confidence and broadly attractive valuations provides the necessary firepower. And, for discerning investors, opportunities to extract value abound.

Cash Return to Shareholders

In addition to business investment and strategic M&A, corporate managements may opt to return some cash to shareholders in the form of buybacks or dividend issuances/increases.

If company management truly believes its stock is undervalued, repurchasing shares could very well be an effective use of funds. Buybacks increase the percentage ownership of all remaining shareholders and are generally viewed as a positive signal that management is optimistic about the future of the company, as well as the economy in general. Buybacks have been a particularly favored capital allocation tool and, notably, have eclipsed the pace of dividend growth (see chart below). It’s important to mention that while buybacks have added value over the long term, the programs have been less effective in recent decades, most notably in the 1990s and 2000s. One of the primary reasons for this is that, in many cases, corporations have bought back their shares at peak levels, thereby diminishing value for shareholders. Another common concern about buybacks is that investors sometimes view them as an indication that management sees few expansion opportunities and, consequently, may decide to invest their money elsewhere. Nevertheless, we think share buybacks can be advantageous if executed at a rational price and if no alternate investments (that would generate a higher return) exist.

Dividends offer another means to reward shareholders and have made quite a comeback since 2009, which was deemed one of the worst years for dividend payouts. While the issuance or increase in dividends can also be taken to mean that a company has limited investment prospects, by and large, we view it as a positive indicator. Not only does it signal management confidence, but also corporate health in that a good dividend record is most often associated with quality companies possessing strong balance sheets with significant free cash flow. Interestingly, while traditional dividend payers tend to be more mature and stable (i.e., slower-growing) firms, the recent dividend movement has expanded to include growth-oriented companies, which characteristically have had no dividend payout. The technology sector is a prominent example of this trend, with Cisco, for example, having recently initiated its first-ever dividend.

Investment Implications

While valuation and growth remain key factors in the investment process of the Large Cap Series, we are also highly attuned to the capital allocation abilities of companies as the related management decisions have a direct impact on shareholder value. This is especially true in the current environment given the ample amount of cash flow to allocate — that is, the rewards of prudent allocation are high for companies that pursue appropriate strategies, but so, too, are the risks that companies squander the opportunity through value-destroying ventures.

With this in mind, we look to firms possessing a strong record of consistent and rising free cash flow, business models with relatively lower capital intensity and cash balances in excess of their investment needs. We believe such companies are best-positioned for the oncoming wave of capital deployment and, thus, have greater potential for delivering superior shareholder returns.

Daniel Wills,Nicholas Brooks, ETF Securities

Gold consolidates gains as Greece edges towards default

Gold price pushes up towards $1540/oz as Greek political instability and European jousting over a new financial package for Greece continued through the weekend. The Greek prime-minister re-shuffled his cabinet and called for a vote of confidence as political opponents and street protests challenged further austerity measures. Meanwhile, Europe continues to play hard-ball, delaying a decision on a new financial package until it is clear Greece will honor its reform obligations.

Non-commercial futures net long positions in palladium, platinum and gold rebound from May lows. Silver net longs, however, continue to fall. Palladium futures notched up their sharpest rise on record last week.

The gold price pushed up towards a new record high as market concern grows that the sovereign debt crisis could broaden into a wider financial crisis. Moody’s placed France’s largest bank BNP Paribas and local competitors Societe Generale and Credit Agricole on review last week, citing their exposure to Greek debt in the event of a Greek default or debt restructuring. With S&P downgrading Greek government debt to the lowest in the world last week, concerns about the possibility of default are running high.

Silver prices trail gold on growth concerns, investor apprehension. The gold:silver ratio ended last week up 38% from its end-April low as gold prices have rallied on investor concerns surrounding sovereign debt and inflation, while silver has prices have been hamstrung by a string of generally weaker activity data in US and Europe over the past month. Silver also remains out of favour from futures investors since the introduction of tighter COMEX silver trading restrictions at the start of May (see below). Interestingly, silver is also the only major precious metal with a backwardated (downward sloping) futures curve.

Silver speculative futures investment yet to recover from post-COMEX margin hike clear-out even as interest in other precious metals rapidly recovers. Speculative futures positioning is barely one-fifth of the levels prevailing prior to the introduction of new silver futures trading restrictions at the start of May and continues to drop, whereas positioning in the other major precious metals has now been on the rise for several weeks. Palladium speculative futures positioning is now above levels seen just prior to the May commodities correction after seeing the fastest weekly rise in positions on record in the week ended June 10.